Emerging Markets

Are emerging market underdogs the best bet?

Leslie Shaffer | Writer for CNBC.com
McCaig | E+ | Getty Images

Instead of chasing emerging markets with strong economic growth, investors may see better gains from poorly performing economies.

"If you invest those economies which have done very poorly over the last five years, the prospects of future return are the highest," Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management, said.

"If you invest in those economies which have done very well over the last five years, the prospect for future returns are limited," he added.

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"Economic success is fleeting," and booms tend to spur countries into heavier debt loads and a sense of political complacency, especially if political leadership has gone "stale," he said. As an example, he cited India, which after a decade-long boom, shifted into a period of policy paralysis, leading to high inflation and low growth.

"Countries only tend to carry out economic reforms when they have their back to the wall," he said. "Once they carry out some economic reforms, you end up getting an economic revival," Sharma said, adding that a leadership change also helps to spur strong equity gains.

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Over the last 20 or so years in emerging markets, "equity markets tend to outperform massively in the next 12-18 months after a new leader comes to power," he said.

"If you look at the best performing markets in the world this year, they've really been markets where they've been anticipating political change and there are reform minded leaders coming to power," Sharma said, noting Asia's two best performers this year have been India and Indonesia, largely on expectations for political change.

But while those two countries still meet his criteria for gains ahead, sentiment on the markets is already optimistic, and the best risk-reward is likely found in emerging markets in Eastern Europe, he said.

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"Sentiment is still so beaten down and yet the balance sheets are in much better shape and the economic recovery is taking place," he said, adding he's positive on Poland, Romania, Greece and the Czech Republic.

But he's keeping an underweight call on Russia.

"When governments are in power for more than 10 years, that's very counterproductive for economic reform and for economic growth," Sharma said.

Others also see a pattern in seeking out the emerging markets' underachievers.

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After the global financial crisis, the BRIC markets -- or Brazil, Russia, India and China -- were the worst performers, but over the past three months, Brazil and India have become among the best performers, noted Tim Seymour, the chief investment officer at Triogem Asset Management.

"India and Brazil are largely better based on politics and the expectation and the hope for change," Seymour said, noting that despite some improvement, India's economic performance remains disappointing with high inflation and a continuing current account deficit.

In addition, "bad news on Dilma (Vana Rousseff, Brazil's president) has been good news for the stock market," he said, but noted that after a 35 percent rise over the last three months, the market may no longer be worth chasing.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter

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